Monday, 20 November 2017

Two Different Ways To Charge For The Same Experience

When I was a young boy my parents used to take me to Great Yarmouth pleasure beach about once a year. For several years I remember that we used to have to pay a fee at the entrance gate and then all rides would be free to go on as many ties as we wanted. Then after a few years the policy changed. From now on, entrance is free but every ride costs a fee, paid for by exchanging cash for tokens.

When the pleasure beach changed payment policy my father was unhappy - he preferred the old 'pay once at the door' system because he felt it was better value for money. In one sense he was right - a one off fee that enables you to keep going on ride after ride until you are ready to collapse is certainly squeezing every drop of value out of the entrance fee. But in another sense, and perhaps the most important sense - the sense of value - the new charging system was better.

Here's why. What my father didn't realise is that there's an important difference between the marginal price of something and the average price. In the fairground, the average price is the fee divided by the number of rides, whereas the marginal price is the price of each additional ride. Once you've paid at the door, the marginal price of extra rides over and above your perceived optimum number is negligible. Paying at the gate and going on just a few rides is a very expensive and inefficient way of going to the fairground - but paying once and being blind to the costs of each extra ride is also bad, because you may end up going on more rides than you want to just to get your money's worth.

This is exactly what its like in 'eat all you can' buffets (still my second most read Blog post) or drink all you can for £20 in a bar - customers very often try to maximise the value of their cost by eating and drinking as much as possible - way beyond what they would ideally consume. You don't need me to tell you that when goods and services are priced in relation to what is consumed (per ride, per meal or per drink) people don't consume so irresponsibly.

Businesses are looking to find the maximum that everyone will pay, translating that to highest charges at the gate or on a per ride basis, and turning that into producer surplus. Of course the Great Yarmouth pleasure beach cannot charge everyone the most they will pay because every customer is different.

But what they can do is average it out; whereby, if customers who would be willing to pay a high price are the ones whose frequency of rides is the highest, then charging on a per ride basis is rather like charging a high entrance price on the gate for those who will pay it, and a slightly lower price for those who will not (although this has to be offset against the fact that charges on a per-ride basis may engender queues that disincentivise some from paying, whereas a pay at the entrance fee won't have this problem).
If you're super-attentive to the pros and cons of these two methods of charging, and can understand this from the perspective of the consumer, you can probably see why a lot of public sector market signals are off whack. For example, with strategies such as aligning public sector pay with inflation, using taxes to fund services that are not naturally public goods, regulations and price fixes that impede free trade, and just about anything that fails to optimise the clear information signals for whether there is commercial demand, you are dealing with a menu of inefficiencies and value-losses.  

For more on these different types of pricing - very apt too, given that Black Friday is imminent - see my blog post here.